Financial Ratios – Money Invest

Financial ratios are metrics calculated from a company’s financial statements to assess its financial health.

Why are they important?

These ratios allow you to compare different companies of various sizes and industries. Ypu can also compare the company against its industry average.
Track a company’s performance over time.
Provide insights for making investment decisions.

Types of Financial Ratios

Liquidity Ratios
Profitability Ratios
Efficiency Ratios
Leverage Ratios
Market Ratios

Liquidity Ratios

Liquidity ratios measure a company’s ability to meet its short-term obligations using its current assets. These indicate whether a company can quickly convert assets into cash to pay off its short-term debts.

a. Current Ratio

Measures a company’s ability to cover its short-term liabilities with its short-term assets.
Current Assets / Current Liabilities
A ratio above 1 indicates that the company has more current assets than liabilities, implying good short-term financial health.
Example: If a company has current assets of $150,000 and current liabilities of $100,000, the current ratio is 1.5. This means the company has $1.50 in assets for every $1 of liabilities.

b. Quick Ratio (Acid-Test Ratio)

Definition: Measures a company’s ability to meet its short-term obligations without relying on inventory sales.
Formula: (Current Assets – Inventory) / Current Liabilities
Interpretation: A ratio above 1 is generally considered good, indicating that the company can cover its liabilities without needing to sell inventory.
Example: If a company has current assets of $150,000, inventory of $30,000, and current liabilities of $100,000, the quick ratio is (150,000 – 30,000) / 100,000 = 1.2. This suggests sufficient liquidity without depending on inventory.

c. Cash Ratio

Definition: Measures a company’s ability to pay off short-term liabilities using only its cash and cash equivalents.
Formula: Cash and Cash Equivalents / Current Liabilities
Interpretation: A ratio above 1 indicates that the company has enough cash to cover its current liabilities, but too high a ratio might suggest inefficiency in using cash.
Example: If a company has $50,000 in cash and cash equivalents and $100,000 in current liabilities, the cash ratio is 0.5. This means the company has 50 cents in cash for every $1 of liabilities.

2. Profitability Ratios

Profitability ratios help in assessing a company’s ability to generate profit. They show how effectively a company is generating earnings.

a. Gross Profit Margin

Definition: Shows the percentage of revenue that exceeds the cost of goods sold (COGS).
Formula: (Gross Profit / Revenue) × 100 OR ((Net Sales – COGS)/Net Sales)*100
Interpretation: A higher margin indicates efficient production and good profitability.
Example: If a company has $200,000 in revenue and $120,000 in COGS, the gross profit margin is (($200,000 – $120,000) / $200,000) × 100 = 40%. This means the company retains 40% of revenue after covering production costs.

b. Operating Profit Margin

Definition: Measures how much profit a company makes from its core operations.
Formula: (Operating Profit / Revenue) × 100
Interpretation: A higher margin indicates that the core operations are profitable.
Example: If a company has $200,000 in revenue and $30,000 in operating expenses, the margin is (($200,000 – $30,000) / $200,000) × 100 = 85%.

c. Net Profit Margin

Definition: Represents the percentage of revenue that becomes net income.
Formula: (Net Income / Revenue) × 100
Interpretation: A higher margin indicates a more profitable company after all expenses.
Example: If a company has $200,000 in revenue and $160,000 in total expenses, net income is $40,000. The net profit margin is ($40,000 / $200,000) × 100 = 20%.

d. Return on Assets (ROA)

Definition: Indicates how efficiently a company uses its assets to generate profit.
Formula: Net Income / Total Assets
Interpretation: A higher ROA means better efficiency in using assets.
Example: If a company has $40,000 in net income and $200,000 in total assets, the ROA is $40,000 / $200,000 = 0.2 or 20%.

e. Return on Equity (ROE)

Definition: Shows how effectively a company uses shareholders’ equity to generate profit.
Formula: Net Income / Shareholder’s Equity
Interpretation: A higher ROE indicates efficient use of equity.
Example: If a company has $40,000 in net income and $160,000 in equity, the ROE is $40,000 / $160,000 = 25%.

3. Efficiency Ratios

Efficiency ratios evaluate how well a company uses its assets and liabilities to generate sales or income. They measure how effectively resources are being managed.

a. Inventory Turnover

Definition: Measures how often inventory is sold and replaced over a period.
Formula: Cost of Goods Sold / Average Inventory
Interpretation: A higher ratio indicates efficient inventory management.
Example: If a company has a COGS of $600,000 and an average inventory of $150,000, the turnover is $600,000 / $150,000 = 4 times per year.

b. Accounts Receivable Turnover

Definition: Measures how efficiently a company collects payments from credit sales.
Formula: Net Credit Sales / Average Accounts Receivable
Interpretation: A higher ratio suggests efficient credit management.
Example: If net credit sales are $500,000 and average accounts receivable is $100,000, the turnover is $500,000 / $100,000 = 5 times a year.

c. Asset Turnover

Definition: Measures how efficiently a company uses its assets to generate sales.
Formula: Net Sales / Average Total Assets
Interpretation: A higher ratio indicates efficient use of assets to generate revenue.
Example: If a company has net sales of $500,000 and average total assets of $250,000, the ratio is $500,000 / $250,000 = 2 times.

4. Leverage (Solvency) Ratios

Leverage ratios (also known as solvency ratios) measure the degree to which a company is using borrowed money (debt) to finance its operations and its ability to meet long-term obligations.

a. Debt-to-Equity Ratio

Definition: Measures the proportion of debt used to finance the company relative to equity.
Formula: Total Liabilities / Shareholder’s Equity
Interpretation: A ratio above 1 indicates higher debt than equity, implying higher financial risk.
Example: If a company has $200,000 in total liabilities and $100,000 in equity, the ratio is 2. This means the company has $2 in debt for every $1 of equity.

b. Debt Ratio

Definition: Indicates the proportion of a company’s assets financed by debt.
Formula: Total Liabilities / Total Assets
Interpretation: A lower ratio indicates lower financial risk.
Example: If a company has $150,000 in total liabilities and $300,000 in total assets, the debt ratio is $150,000 / $300,000 = 0.5, meaning 50% of assets are financed by debt.

c. Interest Coverage Ratio

Definition: Measures the company’s ability to cover interest expenses with earnings.
Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense
Interpretation: A higher ratio means better ability to cover interest payments.
Example: If EBIT is $60,000 and interest expense is $15,000, the ratio is $60,000 / $15,000 = 4. This means the company can cover its interest payments 4 times over.

5. Market Ratios

a. Earnings Per Share (EPS)

Definition: Measures the profit allocated to each share of common stock.
Formula: Net Income / Number of Outstanding Shares
Interpretation: A higher EPS indicates higher profitability per share.
Example: If net income is $100,000 and there are 20,000 shares, the EPS is $100,000 / 20,000 = $5.

b. Price-to-Earnings (P/E) Ratio

Definition: Shows how much investors are willing to pay per dollar of earnings.
Formula: Market Price per Share / Earnings per Share
Interpretation: A higher P/E suggests high growth expectations; a lower P/E suggests undervaluation.
Example: If the share price is $50 and EPS is $5, the P/E ratio is $50 / $5 = 10.

c. Dividend Yield

Definition: Measures the annual dividend income relative to the share price.
Formula: Annual Dividends per Share / Market Price per Share
Interpretation: A higher yield indicates better returns for investors.
Example: If annual dividends are $2 per share and the share price is $40, the yield is $2 / $40 = 5%.

d. Price-to-Book (P/B) Ratio

Definition: Compares the market price of a stock to its book value.
Formula: Market Price per Share / Book Value per Share
Interpretation: A lower ratio may indicate undervaluation, while a higher one suggests overvaluation.
Example: If the share price is $50 and the book value is $25, the P/B ratio is $50 / $25 = 2.